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Referee Finance Award


Vote for the best paper in finance

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The nominees for the Referee Finance Award 2009 have been selected. Please vote for the best paper by clicking on the buttons on the right of this page.

 Results will be announced in December 2010.

Thanks!

 The Referee Finance Team

 The papers can be consulted below:

The Dance on the Edge: A Kalman-Filtered Model of Credit Spreads

by Angelo Corelli

ABSTRACT
The evidence on the relationship between observed spreads and their theoretical determinants is mixed. Using principal components analysis, Colin Dufresne et al. (2001) find that changes in individual bond spreads are driven by a single common systematic factor, unaccounted for by theoretical variables. A stream of recent literature demonstrates that credit risk accounts for a minor portion of spreads, with most variation due to alternative risk factors or a risk premium similar to that in the equity markets. A significant portion of spread levels has attributed to the positive difference between tax rates on corporate and treasury bonds.

Elton, Gruber, et al. (2001) find that expected loss accounts for less than 25% of the observed corporate bond spreads, with the remainder due to state taxes and factors commonly associated with the equity premium. Similarly, Delianedis and Geske (2001) attribute credit spreads to taxes, jumps, liquidity and market risk.
Liquidity risk itself has been found to be a positive function of the volatility of a firm assets and its leverage, the same variables that are seen as determinants of credit risk (Ericsson and Renault 2001). In Statistics and Economics, a filter is simply a term used to describe an algorithm that allows recursive estimation of unobserved, time varying parameters, or variables in the system. It is different from forecasting in that forecasts are made for future, whereas filtering obtains estimates of unobservables for the same time period as the information set. The Kalman Filter (KF) is a discrete, recursive linear filter, first developed for use in engineering applications and subsequently adopted by statisticians and econometricians.
The basic idea behind the filter is simple - to arrive at a conditional density function of the unobservables using Bayes’ Theorem, the functional form of relationship with observables, an equation of motion and assumptions regarding the distribution of error terms. The filter uses the current observation to predict the next period’s value of unobservable and then uses the realization next period to update that forecast. The Linear KF is optimal, i.e. Minimum Mean Squared Error estimator if the observed variable and the noise are jointly Gaussian. Else, it is best among the class of linear filters. This paper attempts to apply a KF to the well known multifactor Vasicek model for Credit spreads.In order to get the result the model has to be first expressed in state space form, so to allow the filter
to apply to the vector latent factors.

You can dowload the paper here

Attracting Flows by Attracting Big Clients

Lauren Cohen and Breno Schmidt

We document a new, economically large, and growing channel, for attracting assets under management: namely the 401(k) market.  In 2004, nearly 40% of all mutual fund assets were held by Defined Contribution Plans and Individual Retirement Accounts. This percentage is steadily increasing largely because these retirement accounts represent the majority of new flows into non-money market mutual funds (60% in 2004).  With such a large and growing percentage of their assets coming from retirement accounts, mutual funds are likely to be interested in securing these big clients. Previous literature on the agency problems associated with increasing funds under management has concentrated on the flow performance relationship. In this paper we examine a new channel through which mutual fund families can attract assets: by becoming the trustee of a 401(k) plan.
 

Families secure substantial inflows by being named trustee. We find that family trustees significantly overweight, and are reluctant to sell, their 401(k) client firm’s stock. Trustee overweighting is more pronounced when the relationship is more valuable to the trustee family, and is concentrated in those funds receiving the greatest benefit from the inflows. We quantify this flow benefit to mutual funds and find that inclusion in the 401(k) plan has an economically and statistically large, positive effect on inflows.

As the percentage of mutual fund assets held by defined contribution retirement plans steadily increases, we expect these 401(k) plans to become more important sources of growth for fund families. Indeed, following the passage of the Pension Protection Act of 2006, projections estimate that 401(k) participation rates will increase by nearly 50% in coming years, vastly increasing the size of 401(k) plans. We therefore predict the importance of the trustee relationship on mutual fund portfolio choice that we document here to increase in coming years.

You can download the paper here

The StressVaR: A New Risk Concept for uperior Fund Allocation


Cyril Coste, Raphaël Douady, Ilija I. Zovko

Summary
In this paper we introduce a novel approach to risk estimation based on nonlinear factor models the ”StressVaR” (SVaR). Developed to evaluate the risk of hedge funds, the SVaR appears to be applicable to a wide range of investments. The computation of the StressVaR is a 3 step rocedure whose main components we describe in relative detail. Its principle is to use the fairly short and sparse history of the hedge fund returns to identify relevant risk factors among  very broad set of possible risk sources.

This risk profile is obtained by calibrating a collection of nonlinear single-factor models as opposed to a single multi-factor model. We then use the risk profile and the very long and rich history of the factors to asses the possible impact of known past crises on the funds, unveiling their hidden risks and so called ”black swans” [1]. In backtests using data of 1060 hedge funds we demonstrate that the SVaR has better or comparable
properties than several common VaR measures - shows less VaR exceptions and, perhaps even more importantly, in case of an exception, by smaller amounts. The ultimate test of the StressVaR however, is in its usage as a fund allocating tool. By simulating a realistic investment in a portfolio of hedge funds, we show that the portfolio constructed using the StressVaR on average outperforms both the market and the portfolios constructed using common VaR measures. For the period from Feb. 2003 to June 2009, the StressVaR constructed portfolio outperforms the market by about 6% annually, and on average the competing VaR measures by around 3%. The performance numbers from Aug. 2007 to June 2009 are even more impressive. The SVaR portfolio outperforms the market by 20%, and the best competing measure by 4%.

 

You can download the paper here

Geography and Local (Dis)advantage: Evidence from Muni Bond Funds

 by David Rakowski

Summary
The combination of geographic and economic data has provided increasingly useful evidence to explain the dynamics of information exchange across spatially distinct areas.

However, the tools offered by economic geography have remained a largely under-utilized resource for explaining the specific factors that drive cross-sectional variation in delegated portfolio management. Our primary innovation is to focus on the unique geography-driven characteristics of the municipal-bond market in order to conduct several clear tests on the relationship between geographic location and investment management. We accomplish this by examining only single-state muni-bond mutual funds, which have rarely been included in the existing studies on mutual fund performance. Our results indicate that, in the case of municipal-bond mutual funds, local (i.e., in-state) fund managers perform significantly worse than non-local (i.e., out-of-state) fund managers.
In addition to our examination of underperformance of local managers of municipal bond mutual funds, we also provide evidence for several factors that influence the performance of muni bond funds in general and that have not been previously documented (to our knowledge). With this we extend the work of Christoffersen and Sarkissian (2009) by showing that the interaction between being local and being located in a state capital or large city has power to explain performance. However, the location of the fund manager is relatively ineffective in explaining performance compared with using the characteristics of the state in which the fund invests. Expanding on the work of Butler (2008) and Butler, Fauver, and Mortal (2009) we confirm that levels of political corruption, freedom of information, and conflict of interest law influence the performance of muni bond fund managers. We add to this evidence that state

click here to download the paper.

Speculative Components of Market Quotations of Financial Assets

by Magomet Yandiew

This study is concerned with financial asset pricing (including that in open trade), an issue that is widely discussed and hard to understand practically. To date, the global scientific thought has created a host of financial asset pricing models, some of which have become known worldwide (for instance, the CAPM model and its varieties), others have not, but the asset pricing and volatility formation mechanisms as well as parameter relationships in trading remain enigmatic. 

The key element of this paper is a set of assumptions that simplifies the current situation in the stock market and enables the processes taking place therein to be formalized. The key assumption excluding any investment activity from the analysis is that no new information has come in the market during the analysis.

 
The main conclusions of the research: 1. The market quotation of any risk asset in free circulation in the market is a sum of values of two independent finance assets. The first one is the market's composite rating of the issuer's discounted cash flow. The second one is the value of the equivalent commercial loan which investors have to extend one another under a tacit term of investor admission to bidding (it is what is known as a Securities Credit, SC). 2. Apart from traditional definitions, the financial asset risk may also be defined as a difference between the actual return and the expected return on a financial asset, i.e. the return required to recover the balanced state of the market (zero asset volatility). 3. A financial asset's risk and return are not interrelated in speculative trading and thus the portfolio theory does not apply thereto. 4. If N of securities are circulating in the stock market, it means N 1 of finance assets are actually circulating in there. An additional asset is the Securities Credit. 5. If the mathematical expectation of return on speculation in financial markets is less than the current rate of return in the interbank credit market, a professional participant will close up his financial activities in financial markets and transfer his assets to the interbank market. 6. Financial markets provide the conditions for manipulative transactions when the mathematical expectation of return on speculative transactions goes below the current value of the interbank market return, with no funds flowing from the stock market to the interbank market. 7. The higher the dealer-estimated probability of success of his speculative strategy, the higher the risk he would be willing to assume (the higher quotation he would be willing to offer). 8. Information is not a mandatory component for the dealer to carry out speculative trading. Certainly he may use it but he is basically indifferent to the information flow. 9. The modern exchange trading system accepted globally, including Islamic countries, violates a few fundamental principles of Sharia and cannot be used in Islamic countries.

 The paper is available here

 Do anti-takeover provisions inhibit disciplinary takeovers and `cause' poor investments? Evidence from the market for corporate control

by Mark Humphery

This article posits that anti-takeover provisions (ATPs) do not cause managers to make value-destroying investments and that this is because ATPs do not  protect managers from disciplinary takeovers.

The literature suggests that firms with more ATPs have lower firm-value and make worse takeovers. The `entrenchment' hypothesis holds that this is because (a) ATPs cause managers to make worse investments, and (b) this is because ATPs cause protection from disciplinary takeovers. The alternative `agency' hypothesis  is that latent agency conflicts cause managers to make worse investments, and this causes managers to adopt ATPs for protection from disciplinary takeovers. Prior tests of limb (a) have focused on long-term value, which is problematic  since ATPs are not new news; and thus, an efficient market should already have priced the impact of ATPs into long-term performance Prior tests of limb (b) have focused on whether ATPs reduce the likelihood of takeovers in general, not whether they reduce the likelihood of a `disciplinary takeover', in specific.   Thus,  this paper re-examines the causality underlying the entrenchment theory using takeover decisions, about which ATPs may convey information. The results indicate that ATPs do not cause firms to make worse takeovers, and  that this is because ATPs do not shield managers from disciplinary takeovers. This suggests that ATPs may not destroy value.

The paper is available here

 

The Dance on the Edge

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THE DANCE ON THE EDGE: A KALMAN-FILTERED MODEL OF CREDIT SPREADS
ANGELO CORELLI
ABSTRACT
The evidence on the relationship between observed spreads and their theoretical determinants is mixed. Using principal components analysis, Colin Dufresne et al. (2001) find that changes in individual bond spreads are driven by a single common systematic factor, unaccounted for by theoretical variables. A stream of recent literature demonstrates that credit risk accounts for a minor portion of spreads, with most variation due to alternative risk factors or a risk premium similar to that in the equity markets. A significant portion of spread levels has attributed to the positive difference between tax rates on corporate and treasury bonds.

Read more...
 

Attracting Flows by Attracting Big Clients

E-mail Print PDF

 Lauren Cohen and Breno Schmidt

We document a new, economically large, and growing channel, for attracting assets under management: namely the 401(k) market.  In 2004, nearly 40% of all mutual fund assets were held by Defined Contribution Plans and Individual Retirement Accounts. This percentage is steadily increasing largely because these retirement accounts represent the majority of new flows into non-money market mutual funds (60% in 2004).  With such a large and growing percentage of their assets coming from retirement accounts, mutual funds are likely to be interested in securing these big clients. Previous literature on the agency problems associated with increasing funds under management has concentrated on the flow performance relationship. In this paper we examine a new channel through which mutual fund families can attract assets: by becoming the trustee of a 401(k) plan.
 

Read more...
 

The StressVaR

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The StressVaR: A New Risk Concept for uperior Fund Allocation


Cyril Coste, Raphaël Douady, Ilija I. Zovko

Summary
In this paper we introduce a novel approach to risk estimation based on nonlinear factor models the ”StressVaR” (SVaR). Developed to evaluate the risk of hedge funds, the SVaR appears to be applicable to a wide range of investments. The computation of the StressVaR is a 3 step rocedure whose main components we describe in relative detail. Its principle is to use the fairly short and sparse history of the hedge fund returns to identify relevant risk factors among  very broad set of possible risk sources.

Read more...
 

Geography and Local (Dis)advantage

E-mail Print PDF

Geography and Local (Dis)advantage: Evidence from Muni Bond Funds

Summary
The combination of geographic and economic data has provided increasingly useful evidence to explain the dynamics of information exchange across spatially distinct areas.

Read more...
 
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